Overconfidence and the Rational Expectations Model of the Term Structure of Interest Rates

Abstract

We propose a behavioral explanation for the widely reported rejection of the rational expectations model of the term structure of interest rates. We distinguish between public and private information and show that overconfidence among investors about the precision of private information can account for the empirical failure of the rational expectations model. Using a simulation experiment calibrated with data on US interest rates, we demonstrate that only a small degree of investor overconfidence is needed to replicate the principle features of the rejections of the rational expectations model that have been documented in different tests in the empirical literature.

Keywords: Rational expectations hypothesis, Term structure of interest rates, Behavioural bias

JEL Classification: C11, G14